Treasury's Ryan Warns Of 'Perfect Storm' In Financial Markets

by Mike Godfrey, Tax-News.com, Washington

13 June 2007

Treasury Assistant Secretary for Financial Markets, Anthony W. Ryan has said that it is 'misleading and imprudent' to dismiss the threat, however remote, of a 'perfect storm' in the financial markets brought about by the potential failure of highly-leveraged hedge funds.

Ryan's comments, made in a speech to the Managed Funds Association Conference in Chicago on Monday, reinforce concerns being echoed by financial regulators globally that the activities of loosely-regulated hedge funds, which now control an estimated $1.4 trillion in assets worldwide, pose systemic risks to the health of highly interconnected markets, and in turn the wider global economy.

"Systemic risk can be defined as the potential that a single event, such as a financial institution's loss or failure, may trigger broad dislocation or a series of defaults that impact the financial system so significantly that the real economy is adversely affected," Ryan noted.

While it is argued by some that the increasing sophistication of risk management systems has largely eradicated this systemic risk, Ryan rejected this view.

"I believe that subscribing to this thesis is both potentially misleading and imprudent," he argued. "Let's begin with answering the question: how could a systemic risk event manifest itself? Meteorologists describe atmospheric conditions conducive to producing a perfect storm. What are the atmospherics for a perfect financial storm? While there would be several, let me name a few: easy credit and leverage, highly correlated strategies, connected and concentrated lenders, inadequate information, and underdeveloped financial market infrastructure."

He went on to warn that: "Stakeholders in our markets must not operate under the false illusion that systemic risk is not a real possibility. Whether examining batting averages or financial market risk, we must account for the possibility of outliers."

In February 2007, the President's Working Group on Financial Markets (PWG) released of a set of principles and guidelines designed to guide US financial regulators as they address public policy issues associated with the rapid growth of private pools of capital, including hedge funds.

The principles were intended to reinforce the significant progress that has been made since the PWG last issued a report on hedge funds in 1999, and to encourage continued efforts along those same lines. The stated goals included:

• Private Pools of Capital: maintain and enhance information, valuation, and risk management systems to provide market participants with accurate, sufficient, and timely information.
• Investors: consider the suitability of investments in a private pool in light of investment objectives, risk tolerances, and the principle of portfolio diversification.
• Counterparties and Creditors: commit sufficient resources to maintain and enhance risk management practices.
• Regulators and Supervisors: work together to communicate and use authority to ensure that supervisory expectations regarding counterparty risk management practices and market integrity are met.

While the Bush administration has traditionally supported a 'hands off' approach when it comes to the operation of the financial markets, Ryan's comments may add weight to arguments by some national regulators and governments, particularly those of Germany and France, that tighter regulation of hedge funds is needed.

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